The Neo-Mercantilist Hysteria Over US Trade Deficits

One of the worst effects of modern Keynesian economics is that its total spending (“aggregate demand”) approach to output and employment provides a pseudo-scientific justification for the central error of mercantilism — an error that dates back to the sixteenth century. According to this ancient fallacy, a deficit in a nation's balance of payments results in a loss of demand, income, and jobs. This doctrine has been demolished time and again by economists during the past two-and-a-half centuries. Yet like the mythical Phoenix the mercantilist myth continually rises from its own ashes.

A few weeks ago the Commerce Department reported that the US trade deficit increased to $47.2 billion in April from $44.2 billion the previous month.1 This $3 billion increase brought forth the usual dire warnings of economic doom from Keynesian neo-mercantilists. Dean Baker co-director of the Center for Economic Policy Research, for example, wrote:

To remind folks who never suffered through a [Keynesian] intro course or forgot their suffering, a trade deficit means that demand generated in the United States is going overseas. Money spent by businesses or consumers is going for goods and services produced in Europe, Mexico, and China rather than in the United States. ... A larger trade deficit has the same implications for the economy as a sudden cutback in consumer spending or business investment. It means less demand and fewer jobs.2

Baker seizes on this small blip in monthly trade balance figures as an opportunity to regurgitate the discredited mercantilist dogma for the billionth time. Using some statistical legerdemain, he projects dire effects of the trade deficit on the US labor market:

Data from a single month are erratic, but the average trade deficit over the three months from February to April was running at an $85 billion higher annual rate than the trade deficit of the prior three months. This means, other things equal, $85 billion more of the demand generated in the United States would be creating growth and jobs in other countries rather than in the United States. ... This loss of demand would translate into roughly 700,000 jobs. This is the result of having consumers and businesses switch their spending from domestically produced items to goods and services that we get from other countries.3

Now there are a few problems with Baker’s argument. First, by annualizing and averaging the three monthly data points, Baker obscures two facts: (1) the trade deficit for February-April actually averaged only $21.25 billion higher than the previous three months; and (2) his claim of an $85 billion increase in the deficit is based on arbitrarily extrapolating these data nine months into the future. Furthermore, by comparing the size of the deficit during these three months to the immediately prior three months, Baker is cherry picking the periods he is comparing to make a projection that is at odds with the recent historical movement in the trade deficit. In fact if we take the two-year period from the end of 2011 to the end of 2013, we get a very different picture: the trade deficit has fallen continually with one slight interruption, from a quarterly rate of over $140 billion to under $120 billion, meaning that over the past two calendar years the average annual trade deficit has actually declined by over $40 billion.4 Baker’s disingenuous appeal to statistics is even clearer when we consider the raw data, which show that the trade deficits for the years 2011–2013 were, respectively, $559.880 billion, $537.605 billion, and $476.392, a clear downward trend.5 (As Murray Rothbard always emphasized, the raw data are always closer to reality than “data” that have been subjected to fancy statistical techniques such as seasonal adjustment, three-month moving averages, chain-weighting, etc.)

Second, even if the trend projected by Baker is realized, other things equal, it would not cause any net loss in jobs at all. What Baker and his fellow neo-mercantilists fail to realize is that every dollar in excess of US exports that is spent by US residents on imports of goods and services from abroad is either spent by foreigners on the purchase of US assets, i.e., invested in US stocks, bonds, bank deposits, real estate, physical capital or are used by foreigners to pay interest and dividends owed to US residents who own foreign assets. In other words, not a single dollar leaves the US as a result of the trade deficit. Checking deposits in US banks are merely transferred from US importers to foreign exporters, who may or may not sell them on the foreign exchange market. In either case, these dollar deposits are ultimately transferred back to US residents by foreigners who wish to invest in US assets or who owe debts to US residents.

Let us take our trade deficit with China as an example. Chinese exporters to the US are not interested in earning and holding dollars which are neither used as payments media in their own country nor yield a return. If they do not wish to use these dollars to buy American products (or to sell them on the foreign exchange market to others who do), then they will use them to invest in US assets that are expected to yield interest payments or profits. Thus, in the last year Chinese investors have used China’s net export earnings to buy up golf courses across the US from California to North Carolina. They have also purchased Sheraton hotels and residential real estate on the West Coast as well as the AMC Theatres chain. Last year alone major Chinese investments in US businesses doubled to $14 billion and are estimated to have reached $8 billion in the first three months of this year.6 In addition, of course, the Chinese continue to invest dollars in accumulating US financial assets yielding interest and dividends.

The neo-mercantilist responds to this by arguing that foreign purchases of US financial assets and (existing) real assets do not replace the decreased spending on currently produced US goods and services that “leaked out” through the trade deficit. But this is based on the discredited Keynesian doctrine that purchasing financial assets is not necessarily equivalent to spending on “real” capital goods. However, the dollars that are invested by foreigners in US stocks, bonds, and financial intermediaries like banks and mutual funds are ultimately lent to or invested in US business firms. These firms then “spend” these dollars on paying wages and buying real capital goods like raw materials, plants and equipment, and software. But what about foreign purchases of real assets like golf courses or hotels that already exist? All other things equal, including domestic “time” or saving preferences, these purchases provide the funds for the US sellers of these assets to invest in starting new projects and enterprises that they forecast to be more profitable and which involves spending on wages and new capital goods.

In short, the so-called trade deficit is exactly equal in dollar terms to net foreign investment in US-based business firms (plus net investment income received by US residents from their foreign asset holdings). The flow of spending in the US economy is not diminished one cent by a negative trade balance but merely re-routed. Accordingly, the “real” effect on the US economy of a trade deficit is a redirection of labor and capital out of its export industries into industries producing consumer and capital goods for domestic use, with no net loss of jobs.

Unfortunately, Baker does not betray the slightest recognition of this analysis. He is trapped in the Keynesian framework in which total spending mechanically drives production and employment and interest rates are always stuck above the level necessary to coordinate the decisions of household to “save” by purchasing financial assets and the separate decisions of business firms to “invest” by purchasing currently produced capital goods. Thus for Baker the trade deficit is a malady to be cured by government rather than a necessary stage of a continuous process in which capital is reallocated to its most highly valued uses in the global economy.

Third, as a neo-mercantilist enlightened by Keynesian economics, Baker shies away from advocating tariffs, quotas, and other crude barriers to trade to remedy the trade deficit. He considers adding spending to the economy via government budget deficits to offset the leakage of spending abroad through the trade deficit, but dismisses the idea: “Government deficits would do the trick but our politicians don’t like budget deficits.” Instead, he argues:

The trick to getting the trade deficit down is a lower valued dollar. This makes our exports cheaper to foreigners, meaning we export more. And it makes imports more expensive, so we buy domestically produced goods rather than imports. ... The way to lower the dollar is simple, we negotiate it.7

In other words Baker is proposing that the US government deliberately engineer a cheapening of the dollar in collusion with foreign governments. Needless to say there are profound problems with this policy. First it involves increasing the rate of growth of the US money supply relative to the rates of monetary growth in foreign countries, especially China and OECD countries. Second, the dollar depreciation can only succeed in shrinking the trade deficit in the short run. Since exchange rates typically respond much more quickly than the prices of goods and services to monetary expansion, dollar depreciation would temporarily lower the prices of US products relative to those of foreign products. This would cause US exports to increase and imports to decline. But once the rate of price inflation in the US finally adjusted to the elevated rate of monetary expansion, the effect of the cheaper dollar would be entirely offset by higher US prices. US products and services would no longer enjoy a price advantage in global markets and the trade deficit would reappear, other things equal, unless the Fed once again ratcheted up the rate of monetary growth.

Furthermore, deliberately cheapening the dollar would wreak havoc with the US economy and reduce living standards of ordinary Americans. In the short run, which could last a year or two, the policy would impoverish most US households by raising the prices they have to pay for imported goods, like those that stock the shelves of Walmart and Best Buy, while lining the pockets of the unionized laborers and crony capitalists who operate in the export industries. In the long run, these same households would suffer the effects of an inflationary boom, asset bubbles in financial and real estate markets, and the inevitable financial crisis and recession.

The real problem is not the trade deficit and the corresponding inflow of foreign capital to the US. In fact this would enhance labor productivity and living standards in the US if these funds were invested in the production of additional capital goods and the creation of new enterprises. The problem is the Federal budget deficit which diverts foreign — as well as domestic — capital flows from productive investment in the US economy to politicians who use these funds to finance wars, corporate welfare programs, crony capitalist bank bailouts, and the expansion of wasteful and destructive government agencies. This deficit suppresses current US living standards and leaves future taxpayers to foot the bill.

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